The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes


Executive Summary

In the United States, workers are being asked to take responsibility for their financial well-being in retirement now more than ever. Most employers today offer defined contribution (DC) plans to their workers as their primary, and often sole, retirement program. The secure retiree income provided by defined benefit (DB) pension plans is becoming a thing of the past. With DC plans, participants must make complex investment decisions that will significantly impact the amount of money they will have available for retirement. Because most workers often do not have the information and knowledge to make these decisions, it is important for DC industry leaders and policymakers to consider the ways in which DC plan structures can improve and evolve to increase participants’ chances for success.

A major concern with DC plans today is the volatility of the underlying accounts, which are invested primarily in a mix of stocks, bonds and cash. Because plan participants fully absorb the gains and losses of their accounts, market events can drastically impact their ability to retire. Consider the example of a worker ready to retire in early 2008 with $500,000 saved in her account, with 50% allocated to equities and 50% allocated to bonds. Between January 2008 and March 2009, global equities lost 41.1% of their value while U.S. bonds gained 4.3%.1 In that environment, this worker, who was nearing retirement and thought she was invested appropriately, would have lost over 18% of her balance. Her accumulated DC wealth would have dropped to around $410,000, potentially putting her retirement at risk.

Including Alternatives in TDFs Can Improve Retirement Income Outcomes

The underlying investments in DC plans need to evolve to improve retirement income outcomes for participants. Target date funds (TDFs) have gained popularity as a DC investment option in retirement plans and as the qualified default investment alternative (QDIA) in part because of their prudent risk management and simplicity. Participants invest in the fund closest to their assumed retirement date and then the fund manager adjusts the mix of stocks, bonds and cash to invest along a glide path to that retirement target date. The glide path is a description of how the various funds that make up a target date product alter their asset allocation over time, moving from riskier assets focused on growth for younger participants into lower risk assets focused on income and capital preservation as retirement approaches.

An advantage offered by TDFs is that the underlying investments can be broadened to include asset classes that have traditionally benefitted other types of long-term investment pools, such as DB plans, without increasing complexity for the participant. Asset classes such as private equity, real estate and hedge funds can be used to create a “diversified TDF” that improves retirement outcomes by diversifying the investment portfolio with alternative asset classes and improving returns when compared with a portfolio solely composed of equities and fixed income.

The strategic use of alternative assets in a TDF structure, or a diversified TDF, demonstrates that including these asset classes can improve expected retirement income and mitigate loss in downside scenarios. As modeled for this analysis,2 a diversified TDF increases the amount of annual retirement income that can be generated by converting a participant’s DC balance into a stream of income at retirement by 17% or $9,200 for every $100,000 of pre-retirement annual wages in the expected case (50th percentile) or by 11% or $2,300 in annual retirement income in a worst-case or downside outcome scenario (5th percentile) (Table 1).

Table 1. Distribution of potential retirement outcomes for a full-career employee3

Participants who retire but retain their assets in the DC plan and utilize the plan for long-term spending in retirement are considered. Including alternative assets improves the probability of not depleting assets over a long-term retirement horizon. A diversified TDF has a higher probability of maintaining positive retirement assets after 30 years of retirement spending; it also provides higher expected returns and lower downside risk at the time of retirement and 10 years post-retirement, mitigating the negative impacts of a short-term market shock for those participants at or near retirement.

Including Alternatives in TDFs: Challenges and Solutions

If alternative assets can make such an important difference in retirement income outcomes and are regularly used in other investment programs, such as DB plans, why are they not often seen in TDFs today?

While progress has been made, DC investment operations and oversight have not yet matured to the level needed to rival those of DB plans. This could be attributable to the DC plan’s historical role as a supplemental savings vehicle in which participants must make more of their own investment decisions. In addition, plan sponsors may be hesitant to implement changes to their programs given the higher perceived fiduciary risks and concerns about possible litigation. The legal obligations of plan fiduciaries, such as the prudent selection of investment options or a reasonable level of fees, have been the subject of a significant number of lawsuits in recent years. However, such fiduciary obligations can be managed through a careful and prudent process focused on enhancing potential outcomes for participants. This includes addressing any concerns such as liquidity and pricing, benchmarking, fees and governance related to incorporating alternative investments into TDFs.

One challenge is the unique feature in DC plans where participants direct their own investments and, in most cases, can change investments daily. Alternative investments such as private equity, real estate and hedge funds are less liquid than other investments because they generally require more time to convert to cash. DC plans typically provide daily liquidity to participants (i.e., the daily ability to access or withdraw funds). While the need for liquidity must be managed, TDFs utilize multiple asset classes by design, providing the opportunity to easily manage liquidity needs within the TDF, including those that use alternatives, through the funds’ allocations to public equities, fixed income and cash. Even over the short term and in a stressed environment, a diversified portfolio including alternative asset classes still has 71% to 76% of its assets available to satisfy daily liquidity, rising to 81% over a three-month (or quarterly) period.4

In addition, given the prevalence of TDFs as a default option (the option in a DC lineup that receives the assets for defaulted participants who fail to elect an investment option), since the passage of the Pension Protection Act of 2006, TDF investors tend not to reallocate their DC investments, which has led to stable inflows. Over the past 10 years, estimated flows have been strongly positive not only at the total target date industry level but also in individual funds.

Discussions about liquidity and pricing often go hand in hand, as many alternative asset classes are not valued daily (consider real estate where the actual buildings are appraised on a periodic basis, typically quarterly). Pricing can also be managed within a TDF structure through utilizing an unbiased proxy to estimate pricing daily. Some DC funds available today allocate to illiquid assets, such as real estate, which estimate pricing in between formal building appraisals within their fund structures to determine a fair value at which the funds transact. The proxy should be as accurate as possible and unbiased, so investors are not advantaged or disadvantaged relative to other investors due to a proxy’s inaccuracy.

Public indices are available to benchmark the performance of TDFs, but the challenge is the asset allocations are often markedly different. Reviewing the performance of TDFs against a reference glide path of market exposures with a comparable risk level provides a basis for an evaluation of the implementation efficacy of TDFs and should be judged accordingly. Each portfolio underlying the TDFs may be benchmarked to an appropriate blended reference portfolio to reveal how the funds have performed from a return, risk and risk-adjusted return standpoint. Additionally, the entire reference glide path may be used to periodically assess the strategic positioning and performance expectations for the funds.

The rise in DC plan lawsuits, in particular those challenging plan fees, has led many plan sponsors to maintain a myopic focus on fees.5 For example, in 2017, passively managed TDFs (those that seek to provide low-cost market exposures) received 95% of the $70 billion in estimated net TDF flows.6 While this may help to manage investment fees, it also severely reduces the investment options available to increase returns and improve performance. It is not particularly controversial to state that participant outcomes are improved as long as the net-of-fee value proposition is positive. Using alternatives is expected to improve net-of-fee outcomes.

When creating a custom TDF to include allocations to alternative investments, the plan sponsor unbundles the responsibilities for creating the strategic glide path, determining asset allocation, building the portfolios using preferred managers, and handling all the operational and communication needs that come with creating a suite of TDFs.

With this comes increased governance needs that are not a function of any established higher regulatory standard of care, but simply an acknowledgement that the complexity of alternative strategies requires additional investment and operational due diligence. Sponsors can supplement inhouse governance expertise by outsourcing remaining tasks to a delegated experienced partner. Delegating some or all of these responsibilities may be an attractive alternative as it provides expertise through a shared fiduciary partner and potentially lowers overall program costs.


For the foreseeable future, DC plans will determine the retirement success for most U.S. workers. Waiting until workers are in the late stages of their careers to determine how successful they have been is simply too late. The time is now to develop a framework for evaluating retirement plan participants’ likelihood of achieving sufficient levels of income for retirement.

To achieve this, plan sponsors must pull all of the levers at their disposal across their organizations, including improving investment outcomes. While a number of important and effective enhancements have been made with investment vehicles (e.g., TDFs, institutionally priced vehicles), plan design (e.g., auto-enrollment, auto-escalation, improved employer match structures) and communications (e.g., administrator technology, wellness platforms), there is one area in which DC plans still lag behind other large investment pools: the use of extended and alternative asset classes. Alternative assets are used more often in other investment pools because they improve investment efficiency and the net-of-fee value proposition by improving retirement income outcomes.7

When DB plans were more prevalent, the need was not as strong to consider the added value generated by the use of alternatives in DC plans. With the growth of DC plans, there is now a greater need for the DC industry to support adoption of strategies that will improve expected investment performance. DC service provider capabilities have vastly improved; operational challenges, including the need for daily liquidity and daily pricing, and the participant-controlled cash flows, can be easily addressed. This can already be seen in the increased use of custom funds in DC plans.

Policymakers should consider these findings about the inclusion of alternative asset classes in DC plans, specifically through target date structures. Even absent any additional action by policymakers, plan sponsors with an interest in implementing portfolios with alternative asset classes can work with their advisors, custodians and recordkeepers to implement solutions that enhance participant outcomes for a more secure retirement.

alternative investments to target-date funds within defined contribution plans can improve returns for participants while not making their lives any more complicated.

So says a policy report from Georgetown University’s McCourt School of Public Policy, which points out that in the absence of defined benefit plans, secure retiree income is “becoming a thing of the past” and the volatility of holdings in DC plans endangers the ability of participants to retire.

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1Global equities are represented by the MSCI ACWI Index, a market capitalization weighted index designed to measure equity market performance in the global developed and emerging markets consisting of 45 country indices comprising 24 developed and 21 emerging market country indices. U.S. bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index, a market capitalization weighted index composed of securities from the Barclays Government/Credit Bond, Mortgage-Backed Securities and Asset-Backed Securities indices. The Index is comprised of all publicly issued investment-grade, fixed-rate, non-convertible, taxable bonds that have at least one year to final maturity and an outstanding par value of at least $250 million.
2Modeling is performed using Willis Towers Watson’s Capital Markets Assumptions, which are described more fully in the Appendix.
3A full-career employee is assumed to participate in a DC plan for 40 years (ages 25 to 65). Savings are assumed to be 4% of wages initially, increasing to 7.5% by age 55 with an employer match of 50% on the first 6% of savings. Annual wages are assumed to increase at CPI +2% until age 45, and only with CPI thereafter, broadly consistent with U.S. Census data.
4Liquidity assumptions sourced from Willis Towers Watson’s Portfolio Management Group.
5George S. Mellman and Geoffrey T. Sanzenbacher, “401(k) Lawsuits: What Are the Causes and Consequences?” Center for Retirement Research at Boston College, no. 18-8 (May 2018).
6Morningstar’s 2018 Target-Date Fund Landscape Paper
7Mercedes Aguirre and Brendan McFarland, “2016 Asset allocations in Fortune 1000 pension plans,” Willis Towers Watson Insider (January 24, 2018).